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Loan Buyer Accounting Is Faulted

WASHINGTON, Feb. 23 - An internal investigation has uncovered new evidence that senior executives of Fannie Mae, the largest buyer of American home mortgages, manipulated its accounting in the 1990's to meet earnings projections so that top executives could receive more than $27 million in bonuses.

In a 616-page report that was released Thursday, former Senator Warren Rudman and a team of lawyers and investigators concluded after an 18-month review that Fannie Mae's accounting practices "in virtually all of the areas that we reviewed were not consistent with" generally accepted accounting principles.

The report, a humbling moment for the political and financial giant, is certain to deepen the political divide in Washington over Fannie Mae, which was created by Congress during the Depression to make home ownership more affordable.

On Thursday, administration officials, some members of Congress and rival businesses said the report showed the need to strengthen oversight of Fannie Mae and limit its size. But the company's supporters in the housing industry and elsewhere said that the report only highlighted the changes that have taken place under its new management.

The findings come as Fannie Mae's regulator considers whether to force some former executives to return bonuses. And the report will not be the final word on the scandal: the Justice Department and Securities and Exchange Commission are still investigating former executives.

Fannie Mae was run with "an attitude of arrogance," according to the report, which catalogs how the company violated accounting principles repeatedly to show stable earnings and less volatility. But the most troubling finding was that the company, rattled by falling interest rates in 1998, improperly delayed taking nearly $200 million in expenses.

That move and other, smaller accounting steps let it meet earnings goals, enabling executives -- including Franklin D. Raines, then the chief executive-designate, and James A. Johnson, the chief executive -- to receive the maximum amount in bonuses for that year.

The report, which was commissioned by Fannie Mae's directors in 2004 after the company was accused by its main regulator of violating accounting rules, laid the responsibility for many of the violations on two former top executives: the chief financial officer, J. Timothy Howard, and the controller, Leanne Spencer. It found that Mr. Raines, a former chairman and chief executive who had served as a top official in the Clinton administration, "contributed to a culture that improperly stressed stable earnings growth."

The report concluded that employees who held vital accounting and financial reporting jobs were "either unqualified for their positions, did not understand their roles, or failed to carry out their roles properly." And it found that management repeatedly presented directors with information that "generally was incomplete and, at times, misleading."

Mr. Raines was ousted from the company in December 2004 after the Securities and Exchange Commission concluded that Fannie Mae had violated accounting rules.

Robert B. Barnett, a lawyer representing Mr. Raines, said Mr. Raines had fully cooperated with the inquiry and was satisfied with the report's conclusions that he did not know that the accounting had violated rules.

"We were disappointed with the report's characterization of Mr. Raines's role in the culture of Fannie Mae," Mr. Barnett said. "Throughout his tenure, Mr. Raines sought to create a leadership culture that focused on openness and good governance."

Steven M. Salky, a lawyer for Mr. Howard, said the report mischaracterized Mr. Howard's "motives and conduct." He said his client acted "with the highest standards of integrity and in the best interests of shareholders."

Ms. Spencer's lawyer, David S. Krakoff, disputed that his client had done anything improper. "The complex accounting judgments were the products of widespread consensus based on the advice of internal experts and the review of external auditors," he said.

The report comes as Fannie Mae continues to struggle through the accounting scandal. The company has not filed an earnings statement since 2004. Later this year, it is expected to make a $11 billion restatement of its earnings going back to 2001. Still, shares of Fannie Mae rose 2.2 percent on Thursday amid relief that the report had concluded that many of the accounting and management problems were being resolved.

The company's main regulator, the Office of Federal Housing Enterprise Oversight, is preparing a report to be issued in the next few months. And Congress, with the urging of the Bush administration, has been preparing legislation that could restrict Fannie Mae and set up a more aggressive oversight agency.

Senator Richard Shelby, the Alabama Republican who heads the Senate Banking Committee, said the report "describes a corporate culture at Fannie Mae that put earnings ahead of any other consideration."

Mr. Shelby's legislation would set up a more aggressive regulatory regime and sharply limit Fannie Mae's business. It was approved on a party line vote by the Banking Committee last July and has run into resistance from Democrats and industry allies of Fannie Mae. The House of Representatives adopted a less restrictive measure four months ago.

Randy Quarles, a Treasury under secretary, said the Rudman report exposed "earnings manipulation and a culture of earnings at any cost, and showed that the enterprise was not focused on its core housing mission."

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While he said the company had made significant progress in cleaning up its accounting and governance structure, it had not reduced the systemic risks posed to the economy by lax rules that enable the company to amass a huge investment portfolio. Fannie Mae and its smaller sibling, Freddie Mac, hold a combined portfolio of about $1.5 trillion.

"We may now have better accounting practices at the institution," Mr. Quarles said. "But that doesn't reduce the risk associated with size of their portfolios."

Fannie Mae provides hundreds of billions of dollars to the home finance market yearly by buying mortgages from banks and savings associations. It keeps some mortgages in its portfolio. Others are repackaged and sold as mortgage-backed securities.

The company has long been a powerful policy player on Capitol Hill and a lucrative landing spot for former government officials.

The report, whose preparation cost the company $60 million to $70 million, found that from 1998 to 2003, the company intentionally set low earnings targets in order to award large bonus and stock option awards.

A central subject of the Rudman report was the company's effort in 1998 and 1999 to deal with the economic fallout of the Russian financial crisis, which caused interest rates in the United States to drop.

That decline prompted many homeowners to prepay then refinance mortgages, leading to an estimated new expense of about $440 million for Fannie Mae. Company officials decided, however, to take only a $240 million expense and defer the remaining $200 million, in violation of an accounting rule.

Regulators had said it had to be more than a coincidence that the deferral enabled the company to hit the earnings targets for maximum bonuses, but until the Rudman report, no evidence had surfaced that directly linked the two.

Mr. Rudman said his team had not uncovered evidence that Mr. Raines deliberately embarked on a course of violating the accounting rules to win larger compensation, although the report found that Mr. Raines had met with Ms. Spencer and Mr. Howard in early 1999 to discuss the plan of deferring $200 million in expenses.

About five months before meeting with Ms. Spencer and Mr. Howard about the deferral, the report said, Mr. Raines got a memo from Lawrence M. Small, then the president and chief operating officer, that emphasized that reaching Wall Street's expectations was important for the bonus program, known as A.I.P., for annual incentive plan. The Wall Street forecast was for earnings of $3.21 a share in 1998 and $3.23 in 1999.

"For 1998, I'm reasonably confident there's enough in the 'non-recurring earnings piggy bank' to get us to $3.21," Mr. Small wrote. "While that number should satisfy investors, you should be aware that last year the A.I.P. paid out just short of the maximum. This year, the maximum is $3.23, so at $3.21, the bonus pool will be noticeably lower than in 1997, a fact which will, of course, be rapidly observed by officers and directors come January."

The report said that the $200 million deferral in expenses was slightly below the target for maximum bonuses, since it raised earnings per share to $3.2285, and the bonus program was based on a calculation of earnings of more than $3.23.

To get to the higher figure, the report said, management decided to take two more steps: change accounting of low-income housing tax credits and reverse about $3.9 million from an account for unreconciled items into profit as "miscellaneous income." The moves bumped earnings per share to $3.2309.

In Congressional testimony and other public statements, Mr. Raines and Mr. Howard denied any connection between the accounting in the 1990's and the attempt to meet earnings estimates to satisfy requirements of the bonus program.

But among the documents uncovered by Mr. Rudman's team was a schedule prepared by Ms. Spencer. The document, which Mr. Rudman said in an interview was the closest thing to a smoking gun, was found when investigators raided Ms. Spencer's office last spring while she was not present.

It set out different earnings projections based expense deferrals that described a plan, ultimately accepted by management, to defer nearly $200 million in expenses to meet earnings projections. After her office was raided, Ms. Spencer declined to answer more questions from Mr. Rudman's team.

Mr. Krakoff, Ms. Spencer's lawyer, said she had "met repeatedly with investigators and made every document available to them."

"She should not, now, be blamed for the investigation's own failure to collect the document sooner."

Mr. Rudman said Mr. Raines had said he had no recollection of seeing the document.

Stephen Labaton reported from Washington for this article and Eric Dash from New York.

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A version of this article appears in print on February 24, 2006, on Page C00001 of the National edition with the headline: Loan Buyer Accounting Is Faulted. Order Reprints|Today's Paper|Subscribe